A rental is a passive activity under IRC § 469, so a rental loss generally offsets only passive income. The main exception for ordinary landlords is the § 469(i) special allowance: if you actively participate, you can deduct up to $25,000 of rental losses against other income, reduced by 50% of modified adjusted gross income (MAGI) over $100,000 and gone at $150,000. Losses you cannot use carry forward, and they are released when you sell your entire interest in a fully taxable sale to an unrelated buyer.

The short version

  • Pub 925: "A rental activity is a passive activity even if you materially participated in that activity, unless you materially participated as a real estate professional."
  • Active participation (owning at least 10% and making management decisions such as approving tenants and setting rent) qualifies you for the $25,000 allowance, even if you use a property manager.
  • The allowance phases out between $100,000 and $150,000 of MAGI. Married filing separately: $12,500, phasing out from $50,000 to $75,000, only if the spouses lived apart all year.
  • Disallowed losses carry forward to the next year and are figured on Form 8582.
  • Real estate professional status needs more than 750 hours and more than half of your personal services in real property trades or businesses, plus material participation in the rental.
  • California treats every rental as passive. The federal real estate professional rule does not apply (R&TC 17561(a)).

The $25,000 allowance and its phase-out

The allowance in § 469(i) is the rule most individual owners rely on. As Pub 527 (2025) describes it:

Filing situationMaximum allowancePhase-out range (MAGI)
Most owners (other than married filing separately)$25,000Reduced by 50% of MAGI over $100,000; none at $150,000
Married filing separately, lived apart all year$12,500$50,000 to $75,000
Married filing separately, lived together at any time during the yearNo allowanceNot applicable

An IRS example. Pub 925 (2025) works through a $31,000 rental loss with MAGI of $120,000. Only $15,000 is allowed, and the remaining $16,000 is carried over to 2026. That is the IRS's illustration, not a figure for your return.

Active participation is a lower bar than material participation. It requires owning at least 10% of the property and making management decisions, such as approving tenants and setting rent. Pub 527 says this can be done while using a property manager.

Form 8582. Form 8582 is "used by noncorporate taxpayers to figure the amount of any passive activity loss (PAL) for the current tax year and to report the application of prior-year unallowed PALs." The Schedule E instructions list an exception for owners who actively participate and meet listed conditions, which include MAGI of $100,000 or less ($50,000 if married filing separately). The deductible loss then goes on Schedule E line 22.

Short-term rentals. Rentals with a short average customer stay can be treated differently under the passive rules. If you rent by the night or week, ask a tax professional how they apply.

Suspended losses: carried forward and released on sale

Under § 469(b), a disallowed loss is treated as a deduction allocable to the activity in the next tax year. The Form 8582 instructions say unused losses carry forward until they are allowed against passive income, against the special allowance, or when you sell or exchange your entire interest in a fully taxable transaction to an unrelated party.

What releases suspended losses, per § 469(g) and Pub 925:

  1. You dispose of your entire interest in the activity, not part of it.
  2. All realized gain or loss is recognized in the transaction.
  3. The buyer is not related to you.

Points to note:

  • Installment sale of the entire interest. Losses are released in proportion to the gain recognized each year. In Pub 925's example, 20% is released in year 1 when $2,000 of a $10,000 gain is recognized.
  • Credits are different. Pub 925 says a full disposition frees "passive activity losses (but not credits)."
  • A § 1031 exchange. Suspended losses generally are freed only by a fully taxable disposition, so an exchange that defers gain generally would not release them. Confirm this with your tax professional.

When you sell, the released losses sit alongside depreciation recapture and capital gain. See selling a rental property.

Real estate professional status

A rental can be non-passive if you qualify as a real estate professional under § 469(c)(7). Both tests must be met for the tax year:

  • More than half of the personal services you performed in all trades or businesses were in real property trades or businesses in which you materially participated; and
  • More than 750 hours of services in real property trades or businesses in which you materially participated.

Details from Pub 925:

  • Hours as an employee don't count unless you own more than 5% of the employer.
  • On a joint return, your spouse's services don't count toward these two tests, but your spouse's participation does count for material participation.
  • Real property trades or businesses include developing or redeveloping, constructing or reconstructing, acquiring, converting, renting or leasing, operating or managing, and brokering.
  • Qualifying is not enough. You must also materially participate in each rental, and each rental is a separate activity unless you elect to treat all interests as one.
  • There are seven material participation tests. The most common is participating for more than 500 hours during the year; Pub 925 lists the others.
  • On the 2025 return, real estate professional information is reported on Schedule E line 43.

Losses that pass the passive rules can still be limited by the excess business loss rules on Form 461.

California differences

RuleFederalCalifornia
Rentals passive by defaultYesYes, always: "For California purposes, all rental activities are passive activities" (FTB 3801 instructions, 2025)
Real estate professional exception, § 469(c)(7)Available if you qualifyDoes not apply (R&TC 17561(a))
$25,000 active participation allowanceYesYes, on FTB 3801, with $150,000 as the phase-out end ($75,000 for married/RDP filing separately and living apart all year)
Married filing separately who lived togetherNo allowanceNo allowance
FormForm 8582FTB 3801

The FTB says California law is generally the same as federal law on passive loss limits, but differences such as the real estate professional rule may make your California passive loss different from your federal one. A loss you deduct federally as a real estate professional may be limited or suspended for California, which produces a Schedule CA adjustment through FTB 3801. Keep separate federal and California carryover records.

What to do next

  1. Confirm your ownership share and write down the management decisions you make, such as approving tenants and setting rent.
  2. Find your prior-year Form 8582 and FTB 3801 for suspended loss carryovers by property.
  3. If you are considering real estate professional status, keep a dated log of hours and services.
  4. Before selling, ask your CPA how much suspended loss would be released and whether the sale is fully taxable.
  5. Ask how the California rules change your result if you claim real estate professional status federally.

Run the property's numbers in the rental cash flow calculator. Coronado owners can see taxes on a Coronado rental, and service members can read California taxes for military homeowners.

Frequently asked questions

Can I take the $25,000 allowance if a property manager runs my rental?

Yes, if you still actively participate. Pub 527 says active participation means owning at least 10% and making management decisions such as approving tenants and setting rent, and that this can be done while using a property manager. Your MAGI still sets how much of the allowance you can use.

What happens to rental losses I can't deduct this year?

They carry forward. Under § 469(b), a disallowed loss is treated as a deduction for the activity in the next year, and it keeps carrying forward until it can be used against passive income, through the special allowance, or when you dispose of your entire interest in a fully taxable transaction to an unrelated party.

Does selling the rental free all my suspended losses?

A fully taxable sale of your entire interest to an unrelated buyer releases them, so the remaining losses are treated as not passive. An installment sale releases them in proportion to the gain recognized each year. Passive credits are not freed this way, and an exchange that defers gain generally does not release them.

Do I qualify as a real estate professional if I have a full-time job?

The test looks at all of your personal services for the year: more than half must be in real property trades or businesses in which you materially participate, and those hours must exceed 750. Work in a job outside real estate is part of that total, and hours as an employee count toward the real estate side only if you own more than 5% of the employer. Your tax professional can review your hours against both tests.

Does California follow the real estate professional rule?

No. R&TC 17561(a) says § 469(c)(7) does not apply, and the FTB says all rental activities are passive for California. A loss you deduct federally as a real estate professional may be limited or suspended on your California return.

This is general information, not tax or legal advice. Tax rules change and depend on your facts; talk to a CPA or enrolled agent before acting.

McKee Properties manages rentals from its Coronado office; contact us with questions about your property.

Sources

Verified October 19, 2026.

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